Simple interest, the cost of using or borrowing money, ignores the effect of compounding or "interest on interest." The biggest benefit of simple interest is that it's relatively easy to calculate, since you only need to compute it on the principal amount of a loan or deposit, rather than on the principal amount and accumulated interest of preceding periods, as is the case with compound interest. (For more, read: Learn Simple and Compound Interest).
Compound interest works to your advantage when you're an investor but works against you when you're a borrower. For example, a credit card debt of $10,000 carried for five years at an annual interest rate of 20% (compounded monthly) would turn into a debt load of $26,960. This means that the compound interest on $10,000 of debt would work out to be a whopping $16,960 over a five-year period.
But in the exceedingly rare instance that the aforementioned credit card debt attracts simple interest at 20%, the total interest over five years would be $10,000 (i.e., $10,000 x 20% x 5 years), rather than the $16,960 payable in compound interest. (For more, see: What is the Difference Between Compounding Interest and Simple Interest?)
So simple interest essentially works in your favor when you're a borrower but against you when you're an investor (as you'll want your returns to compound as much as possible). Here are four ways in which simple interest is often used in real life situations:
- On certificates of deposit for periods of one year or less: If you invest $100,000 in a one-year certificate of deposit (CD) that pays interest at 2% per annum, you would earn $2,000 in interest income (i.e., $100,000 x 2% x 1 year) after a year. If the CD pays the same annual interest rate but is only for a six-month period, you would earn $1,000 in interest income after six months.
- On car loans: Car loans are amortized monthly, which means that a portion of the loan goes to pay the outstanding loan balance every month, and the remainder goes towards the interest payment. As the outstanding loan balance diminishes every month, the interest payable reduces, enabling a greater part of the monthly payment to be allocated towards principal repayment. For example, assume you have a car loan of $20,000, on which simple interest is payable at 4%; the loan is repayable over a five-year period in equal installments. Using a auto loan calculator, the monthly payment works out to $368.33 over 60 months. In the first month, the interest payable on the full $20,000 loan amount is $66.67 (i.e., [$20,000 x 4%] / 12), which means that principal repayment is $301.66 (i.e., $368.33 – $66.67). At the end of the first month, the principal amount is $19,698.34, on which interest payable is $65.66. Thus principal repayment in the second month is $302.67, and so on. By the end of the 60th month, the loan amount outstanding will be zero.
- Other loans (consumer loans): Department stores often offer major appliances on a simple interest basis for periods of up to one year. So if you buy a refrigerator for $2,000 and pay simple interest at an annual rate of 8% in monthly installments, your monthly payment would be close to $174. This means that you would end up paying a total of $2,088, for total interest expense of $88. This is substantially less than the $160 you would have paid in interest expense if you had carried the $2,000 loan for the full year, instead of repaying a portion of it every month.
- Discounts on early payments: In the business world, suppliers often offer a discount to encourage early payment of their invoices. For example, a $50,000 invoice may offer a 0.5% discount for payment within a month. This works out to $250 for early payment, or an annualized rate of 6%, which is quite an attractive deal for the payer.
The Bottom Line
Simple interest is used in a number of situations in real life. While it's easy to calculate for basic situations, if the loan amount is being amortized, the calculation becomes more involved and may require the use of a calculator or spreadsheet.